Embracing the Black Swan - The Insider
By James Davies
Swans and stock markets might appear to be very different. The study of ornithology and economics are unlikely bedfellows, but you'll be surprised to discover that there is, in fact, a connection.
More on this in a moment, but first it would be useful to state an unpleasant truth about stock markets.
Investing in the stock market can be a lesson in dealing with the unexpected. The last decade has delivered several sudden falls in equity valuations. Events like the Asian Financial Crisis of 1997, the 1998 Russian Financial Crisis, the 2000 ‘dotcom' bubble, 11 September 2001 attacks and the current credit crisis have all caused global stock markets to move downwards dramatically. Following such events, analysts, economists and commentators trawl through the data and announce that the events were actually rather predictable; and place the blame at the door of some individual or institution. Hindsight, as they say, is a wonderful thing.
Stock markets do not like uncertainty; and normally react with a shiver or a sneeze when they encounter something out of the blue. Even an unexpected movement in interest rates is enough to send stocks rallying or falling. So how does this relate to the swan in the title of this article? Or more particularly, Black Swans?
Until a little over 300 years ago, it was normal in Europe to use the term ‘black swan' as a metaphor for something that could not exist; an impossibility. Why? Well, if there was one thing that Europeans knew about swans, it was that they were all white: it was the principal ingredient of ‘swaniness'. That is until 1697, when Dutchman Willem de Vlamingh brought back reports from Western Australia of swans that were black. Since then ‘black swan' has started to be used as a term for something that was unexpected. According to polymath Nicholas Nassim Taleb, a black swan event can be defined more specifically as a high impact, hard to predict event that shatters our existing understanding or order of things.
Taleb argues that most events of significance in human history are black swans i.e. unexpected. As humans, one of our faults is not that we were unable to predict these events, but that we use hindsight to convince ourselves that they were predictable, says Taleb. Examples of black swan events include the Black Death of the 1340's, the assassination of Arch Duke Franz Ferdinand in 1914, the development of the internet or the 11 September 2001 terrorist attacks. All these events, hindsight aside, were almost entirely unforeseen, but their consequences long lasting and wide reaching. Such a flaw has obvious ramifications in the field of fund management where fund managers and analysts often seek to extrapolate past events out into the future.
The problem lies in that our understanding of risk (and particularly investment risk) is incapable of taking into consideration the unexpected. We build risk models around what we know, but these models are useless when faced with an event that we did not expect.
This problem was perhaps described most succinctly by the great American philosopher, Donald Rumsfeld, when he said: "There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know". Rumsfeld perhaps isn't a great philosopher, but on this point at least there is a nugget of truth in what he says.
It is the inflection point around when an ‘unknown unknown' becomes a ‘known' that we see extreme stock market volatility. When volatility strikes it is particularly alarming for smaller investors who are less able to weather the storm; and the uncertainty can lead to a degree of panic. As Mark Robinson of Berry Asset Management says, Black Swans "can cause investors to behave irrationally, particularly over short time horizons". Analysis of risk often focuses on volatility; but this is always going to be a retrospective measure, and while useful, it can no more tell you about future risk than past performance can tell you about future returns.
Thankfully there is one simple tool that can be used to limit volatility as far as investments are concerned. Interestingly, this same tool can also be used not only to reduce the effect of black swan events on a portfolio, but also to actually take advantage of them. The tool in question is diversification; and from a portfolio construction point of view, principally, asset diversification.
Investing in multiple asset classes helps reduce exposure to any one particular black swan. For example, following the Russian Financial Crisis the FTSE 100 Index fell -18.1% between 19 August 1998 and 5 October 1998; but over the same period commercial property as measured by the IPD UK All Property Index rose 1.7%.
This helps to show how by adding just one more asset class, you can protect your portfolio from calamitous events. According to Robinson, "investing in multiple asset classes can help reduce the impact of black swan events, and cushion against some of the worst effects".
Multi-Asset investing, however, by exposing your investments to many different types of assets, also increases your chances of being exposed to a black swan. Far from being a bad thing, such an outcome is, in fact, desirable. The reason for this is simple. Not all black swans are catastrophic or negative events. As you might have already realised, many unexpected events in history have had a positive impact (at least from a somewhat relative viewpoint - but we will avoid getting into alternative historical outcomes in this piece). Or, negative events have provided opportunity for those who were in the right place at the right time. The collapse of the Soviet system in Eastern Europe and the development of the internet, for example, were both widely unforeseen, yet both have had a positive impact on the global economy, from where we stand today; providing increased opportunity for investment and a more global market. It would probably be difficult not to benefit from these two events, but, while the recent credit crisis has been bad for most equity investors, if you invested in gold, you would have done very well. Again, being diversified is all important. We are currently going through period of economic uncertainty; but perhaps it is more the case that we are more acutely aware of just how fragile all of our systems and models, in which we put so much trust, are.
Whatever course the global economy follows over the next few years the black swan theory would suggest that it is highly unlikely to follow the route of the prevailing consensus. Being diversified is as much about maximising opportunity as it is about reducing risk. The boom investment of the next 5 years could be anything from shipping to solar cells, commodities to carbon trading. If Willem de Vlamingh was interested in reducing his risk, he would never have left Amsterdam all those years ago and we would probably never have heard of him. It wouldn't have changed the fact, however, that black swans do exist and that sooner or later, one will come along.
Finally, John Stuart Mill, the economist and real philosopher said: "No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion". The lesson for today's investor is to diversify away from just one type of holding or investment strategy and avoid listening only to those who say that all swans are white.
Diversification reduces risk, but it can also increase opportunity. An investment is about the future, yet nearly all analysis looks at past data. By making use of multiple asset types within a fund, the manager increases his or her chances of benefiting from unforeseen future markets - either existing or entirely new. The future is always uncertain and unpredictable; sometimes we are just more aware of it than at other times. It is always worth ensuring that an investment portfolio is positioned for many eventualities.
Sources:
James Davies, Investment Research Manager, comments on a variety of financial subjects on a fortnightly basis in Minerva', our regular email bulletin. To receive a copy of Minerva, please complete the reply card at the back of this publication.
Mark Robinson is a Director at Berry Asset Management and Fund Manager of the Chartwell Cautious Growth Fund.
Nassim Nicholas Taleb - "The Black Swan: The Impact of the Highly Improbable" 1997 Random House.
Data obtained from Financial Express Analytics, May 2008.
